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New York - Call it a correction overdue, but to Doug Ramsey, the convulsions that have shaken equity markets for the past week have hallmarks of something bigger, perhaps an end to the era of tranquility that has reigned on Wall Street for half a decade.
To a greater extent than 24 different previous pullbacks since 2009, he says, this one arrived to distinct signs of froth.
Bitcoin’s 20-fold run-up. Individuals streaming into the market. Equity funds getting record cash. In contrast with euphoria years like 2017, bond yields are rising with increasing momentum, something that has historically spelled trouble, according to the chief investment officer of Leuthold.
“What we saw in January was sort of the psychological peak of the entire bull market,” said Ramsey, who helps oversees $1.5 billion in Minneapolis and cut equity holdings just before the selloff.
“The sentiment peak usually occurs a number of months, sometimes up to a year, in advance of a market peak. There is a chance that we put in a top somewhere in that window.”
Ramsey has a solid record of prescience. His optimistic view in 2013 proved correct and he was a bull market advocate until late 2014, when he got nervous because of weakening breadth.
While the S&P 500 didn’t go down as much as he thought, it was locked in a trading range over next 18 months, suffering two 10% corrections.
How do bull markets end? Sometimes suddenly, but often in a slow burn where signs of nervousness gradually multiply. In 1999, the last year of the internet bubble, the Cboe Volatility index averaged 24.4 - more than twice its level in 2017. Declines in the S&P 500 exceeding 5% occurred six separate times that year, even as the index returned 20%. It had three similar retreats before peaking in 2007.
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“As different scenarios work through the system, volatility should increase,” said Malcolm Polley, who oversees $1.2bn as president and chief investment officer at Stewart Capital Advisors in Indiana, Pennsylvania.
“The end of a cycle tends to happen because of any event - most of these events are either unknown or unexpected so the market doesn’t know how to discount that.”
Little in the economic data or corporate earnings indicates trouble is looming. Growth in gross domestic product is projected to be 2.6%, while stock analysts have been upgrading earnings estimates at the fastest pace in six years. Unemployment is at a 17-year low. None of that has been enough to keep daily stock swings from doubling in 2018, at least over the first six weeks.
The imperfect relationship between late-cycle stock volatility and the economy was on display at the end of the dot-com bubble, too.
In the US, turbulence was rife in equities at a time when GDP was expanding by nearly 5% and unemployment was on its way to a 30-year low.
Things were a little less robust in 2007, though no quarter that year saw an economic contraction or joblessness of more than 5%. Ramsey cautioned against one threat, spiking Treasury rates, in a market where valuations are the highest level since the dot-com era.
Their peril was on display last week, when 10-year yields climbed to a four-year high, fuelling the worst stock decline in two years. A model giving him pause today compares the pace of deterioration in bond prices to the equity market.
Leuthold’s Dow Bond Oscillator, which looks at how quickly returns are weakening in corporate credit, just flagged a warning that the rise in yields is too fast for stocks to escape.
The model, using the 10-week exponential moving average of the 26-week percentage change in the Dow Jones Corporate Bond Index (which measures price, the reciprocal of yields), suggests that the lower it goes, the tighter monetary conditions. And therefore the worse for stocks.
The indicator last month dipped below zero for the first time since June, triggering a sell signal for shareholders. Negative readings have corresponded to lower stock returns since 1920, with the Dow Jones Industrial Average falling at an average annualised rate of 0.3%. Equity performance was better, rising 11%, when readings were above zero.
“Even if yields just flatten out for the next several weeks, it’s going to stay in negative territory because you’re looking versus six months ago,” Ramsey said. “People say as long as rates are low, it’s the critical factor supporting stock market valuations. This would say, ‘No. It’s the rate of change that matters.”’
To be sure, nothing in the market breadth or price momentum suggests that the S&P 500’s record reached on January 26 marked the end of the rally.
In fact, from small caps to transports, technology to financials, everything hit multi-year highs around that time while the S&P 500’s relative strength indicator spiked, a sign that it’s too soon to claim the death of the bull market.
Bull cycle
But danger is growing now that this bull cycle is six months away from becoming the longest in history. For a glimpse of how the topping process may unfold, look to 2007 as a roadmap, says Ramsey. Back then, stocks suffered a correction from July to August.
As the S&P 500 started bouncing back, fewer and fewer stocks managed to keep up. Small-cap trailed, transports lagged behind and once tech heavyweights failed to hold up, the selloff cascaded into a bear market.
“It’s going to be this topping parade,” Ramsey said. “Maybe now we’ve gone down hard for a few days, something that has been knocked down among these bellwethers don’t come back and make new highs. This crack sets up for the last rally leg.”
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